Saturday, September 29, 2007

Should I Pay Down My House Early If I Can?

Assume you just inherited a bundle of capital from your long lost uncle and you could pay off your house today; should you do it? I don't think there is really a right answer to this question, but what I will do here is walk you through how I think about it.

First, what is the current rate you are paying on your mortgage ? Take this rate and then multiply by 1-your tax rate. This should be your after tax cost of debt. So let's say you have a fixed mortgage at 6%. If you are in the 25% tax bracket then your after tax cost of debt should be 6% * (1-25%) or 4.5%. You need to have a safe investment that has a better after tax return than to justify not paying off your house.

Next, consider your investment options. I would look only at nearly risk free investments. For instance 10 year treasury bonds trade at 4.58%. Multiply this by (1-25%) to find your after tax return which would be 3.43%. Based on this analysis you are better off paying your house off than putting money into 10-year treasuries because you get an after-tax risk free return of 4.5% by doing it. Likewise, it looks like most CDs don't have enough of a yield today to suggest that you shouldn't pay off your house.

But what about putting the money in the stock market? After all doesn't it return 8% or so on average? In general the answer is yes, but the reason that you get an 8% return instead of 4.5% from treasury bonds is that there is more risk associated with this decision. In general if you were to just invest the money and pay off the house later you should be better off in the long run. However as a conservative Armchair Fiduciary, I feel like doing this would be taking too much risk. You can always pay off the house and then take what you would have been paying in monthly payments on the mortgage and invest it in the market. This may lead to somewhat less long-term wealth on average, but it is the much less risky option in my opinion. Better safe then sorry in my opinion. Got a better idea? Leave a comment.

4 comments:

Anonymous said...

While I agree with your math and generally agree with your analysis, I think you need to consider the option value of cash in hand vs. the cost of having cash.

Hypothetical: I have $10,000 in a saving account earning 4%. With taxes, my after-tax income is 3%. If my mortgage has an after tax cost of 4%, your analysis would say pay down the mortgage and pocket the spread.

But, when you have cash, you have an option. Let's say I have an emergency (house, car, health, etc) and suddenly need $10,000.

If I paid the money to the mortgage company, they are not going to give it back unless I incur significant expenses. As a result, I would need to tap expensive "borrowing" such as credit cards or HELOC.

Armchair Fiduciary said...

Fair point. I agree with that analysis on optionality, but I think you should 1) already have some sort of emergency fund (and definitely before you consider pre-paying a mortgage) and 2) will be able to build up some cash pretty quickly once you don't have those pesky monthly payments to deal with thus replenishing some of this optionality. Bottom-line, I am still sticking by my analysis, but the optionality point is a good one especially if you don't have an emergency fund.

robert said...

I think readers should also be aware that the standard deduction eliminates a large percentage of the mgt dedution, unless you itemize your deduction. The effective interest rate for the mtg note is actually much higher for people who dont itemize.

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